Session 20.

Derivatives and Risk Management

PGP, IIM INDORE
Calls and Puts
Two types of options, call and put, each with same degree of risk
Call Option
◦ The holder has the right to buy an asset at specified price on or before exercise
date
Put Option
◦ Holder has the right to sell asset at specified price on or before exercise date
Calls and Puts
•Option Obligations
•Buyer of an option: Long position in the option
•Seller (Writer) of an option: Short position in the
option
Long Short
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
Options on Hindustan Unilever Stock, October
2013
•HUL was trading at Rs. 600
•For the same exercise price: Option price
increases as the option maturity is extended
HUL Position Diagram: Payoffs to owners
of HUL Call option
•Option Value: Value at
expiration is a function
of stock price and
exercise price
Payoff to Seller of HUL Call
HUL Position Diagram: Payoff to owners
of HUL Put option
Payoff to Seller of HUL Put
Selling Options
•The seller (or writer) of an option has an obligation.
•The seller receives the option premium in exchange.
Profit Diagram for the Owners of HUL
Call option
Profit Diagram for the seller of HUL Put
option
Calls, Puts, and Shares
Derivatives
◦ Financial instrument created from another instrument

Option Premium
◦ Price paid for option
Exercise Price (Strike Price)
◦ Price at which security is to be bought or sold
American option
◦ Can be exercised any time up to expiration date
European option
◦ Can only be exercised on expiration date
Options
In-the-Money
◦ Exercising the option would result in a positive payoff (cash flow).
◦ Call option – exercise price is lower than the market (spot) price
◦ Put option – exercise price is above the market (spot) price

At-the-Money
◦ Exercising the option would result in a zero payoff (i.e., exercise price equal to spot price).

Out-of-the-Money
◦ Exercising the option would result in a negative payoff.
Forwards and Futures Contracts
Forward Contracts
•A forward contract specifies that a certain commodity / asset will be
exchanged at a specified time in the future at a price specified today.
• Its not an option: both parties are expected to hold up their end of the deal.
• There is a counterparty default risk – one of the parties may refuse to honor the contract
Forward Contract example
• Example: Agrawal Jewelers, requires 100 kg of gold to deliver gold jewelry before Christmas
to the a trader in Dubai
• Agrawal worries about the high gold prices in future and wants to lock in the cost of buying
gold
• Shah Gold mines, extracts gold, and plans to sell gold before December. He worries about the
adverse change in gold prices, and wants to lock in the price
• Agrawal agrees in August to buy 100 kg gold from Shah at Rs. 28000 per 10 grams, to be paid
on delivery in November
• Therefore, two counterparties with offsetting risks can eliminate risk by hedging through
forward contracts
Futures Contracts
•A futures contract is like a forward contract:
• It specifies that a certain commodity will be exchanged at a specified
time in the future at a price specified today.

•A futures contract is different from a forward:

• Futures are standardized contracts trading on organized exchanges,
settled through a clearinghouse.
• Since traded on an exchange: more liquid market in futures
• There is counterparty risk in Forward contracts. Futures contracts are
marked to market (daily resettlement of gain or loss)
Types
Equity derivatives : Options and futures in stock and indices
◦ NSE and BSE Equity derivatives segment
◦ In stock options, the buyer has a right not an obligation
◦ In stock futures, both the buyer and the seller are obliged to buy/sell the underlying stock

Other financial assets: Currency Futures, Interest rate futures (Bond futures)
Commodities: Options and futures trading in Non-ferrous metals, agricultural products, oil, gold
◦ MCX (Multi-commodity exchange), NCDEX (National Commodity and Derivatives Exchange), etc.
Why manage risk?
Why Manage Risk?
•Risk management: Managing the exposure of a firm’s earnings, cashflows, or market value to
external factors such as interest rates, exchange rates, commodity prices, and other factors
•Risk: when expected return (outcome) can be different from actual
•Does risk management create value?
•Various modes of mitigating risk:
• Insurance
• Hedging (Forwards, futures and other derivatives)
• Diversification
Does risk management create value?
•Extending the logic applied in M&M Propositions on Capital Structure and Dividend policy
• One could show that risk management is irrelevant (under certain assumptions)
• Therefore, corporate risk management should not affect firm value, since investors can do the same
equally well.
Does risk management create value?
Contd.
•However, there are certain market imperfections that make risk management relevant
•Asymmetric Information: Company has greater information on the potential risks
•Transaction costs and barriers to entry: Retail investors may not have access to select derivatives
on account of the size of a transaction
•Financial Distress: Reduce financial distress through risk management, and improve financial
flexibility
•Investment policy: Firms involve in cash flow hedging and therefore ensure steady stream of
internally generated funds required to make necessary investments
•Managerial Concerns: Managers may manage risk to protect their own non-diversifiable
employment risk
References
Tufano, P. & Headley, J. S. (1994). Why Manage Risk? HBS No. 9-294-107. Boston, MA: Harvard
Business School Publishing
BM: Ch 20 (Section 20.1) and BE: Ch 23